Better cures for bubbles than rate hikes, Fed's Kohn warns

Central banks should refrain from raising interest rates to pop potential asset bubbles, the vice-chairman of the U.S. Federal Reserve said Thursday, indicating his preference is for "prudential" regulation and supervision of the financial system.

In a speech in Ottawa, Donald Kohn attempted to outline some of the lessons learned from the financial crisis. Some observers have indicated the U.S. mortgage crisis was the result of the Fed keeping rates too low for too long for much of past decade. But Mr. Kohn said raising rates to stem growth in asset prices, like housing, is not necessarily the way to go, and doesn't believe that should be an added responsibility for the Fed, on top of price stability and employment.

"I don't minimize the difficulties of executing effective macroprudential supervision, nor do I rule out using interest rate policy in circumstances in which dangerous imbalances are building and prudential steps seem to be delayed or ineffective," said Mr. Kohn, whose speech kicked off a two-day monetary policy and economics conference at Ottawa's Carleton University. "But I do think regulation can be better targeted to the developing problem, and the balance of costs and benefits from using these types of instruments are far more likely to be favourable than from using monetary policy to achieve financial stability."

Afterward, in a question-and-answer session with the roughly 100 delegates in attendance, he expanded on his “reservations,” noting raising rates to stem housing growth would have unintended consequences.

"I would raise interest rates to dampen a housing bubble [while] at the same time dampening business investment, growth in durables and exports through the effect on the foreign-exchange [market],” Mr. Kohn said. "It is much better if we can do it by … targeting something to the house price situation itself,” and the activity in the mortgage market."

Concerns about a possible housing bubble in Canada prompted the federal Finance Minister, Jim Flaherty, to introduce new rules in February that make it tougher for possible buyers to qualify for mandatory mortgage insurance.

Mr. Kohn is set to retire late next month, and is set to be replaced by Janet Yellen, president of the San Francisco Federal Reserve Bank.

Meanwhile, Mr. Kohn addressed other developments on the monetary policy front that evolved through the crisis.

He said commitments to maintain interest rates at a given level -- like the Bank of Canada did through their conditional pledge -- must be properly conditioned on the evolution of the economy. "If they are to achieve their objectives, central banks cannot make unconditional interest rate commitments based only on a time dimension," Mr. Kohn said, noting the Bank of Canada ditched its conditional commitment on the basis of a faster-than-expected recovery.

The Fed has adopted a similar pledge, by indicating it intends to keep its policy rate at "exceptionally low" levels for an "extended period." Mr. Kohn said that guidance is dependent on the outlook for inflation, the potential output gap and employment levels.

He also cautioned against central banks adopting higher inflation targets, as has been suggested by the International Monetary Fund's top economist, Olivier Blanchard.

"Increasing our inflation targets could result in more-variable inflation and worse economic outcomes over time," he said. "A higher inflation target might also mean that inflation would be higher than can be ignored, and businesses and households may take inflation more into account when writing contracts and making investments, increasing the odds that otherwise transitory inflation would become more persistent."

(prepared by Paul Vieira/Financial Post/Vancouver Sun)